Three weeks after the PBOC cut its Required Reserve Ratio, overnight the PBOC engaged in additional stealth easing.

As we reported last night, the most notable easing shift was that the Chinese central bank would use its Medium Term Lending Facility (MLF), to support the local bond market and banks, especially those that have invested in bonds rated AA- (the local version of high yield) or look to buy more junk bond exposure, according to local press. Effectively, Beijing will directly flood banks with additional liquidity – a stark reversal to its deleveraging posture – with one simple instruction: “increase bank lending and bond purchases.” And since all Chinese banks are essentially state owned, what Beijing has done is launch a form of stealth QE, one where it’s not the central bank, but the country’s various commercial banks that do the bond purchases, using central bank liquidity via the MLF which currently has some 4.4 trillion yuan outstanding, or $650 billion.

However, in a separate and less noticed move, the PBOC also engaged in direct easing by cutting rates, however not using conventional means such as reducing the RRR or the interest rate on the 7-day policy rate, instead the the PBOC cut borrowing costs through an unusual tool, one which according to ING Bank indicates that China is cautious about sending an obvious signal that it’s loosening policy… and further angering Donald Trump.

Specifically, the PBOC lowered borrowing costs by guiding auction rates on the 91-day Treasury Deposit Rate at commercial banks, down to 3.7% from 4.73% in June. This brought the 91-day (or 3-month) Treasury deposit rate to the lowest since October 2016.

As Nomura further explains, on July 17, the Ministry of Finance (MoF) and the PBoC deposited RMB150bn of Treasury with a 3-month tenor at commercial banks through a bidding process. Winning banks offered an interest rate of 3.70% for the Treasury deposit, which was 103bp lower from the last bid on June 15. Although the bidding mechanism for
Treasury deposits suggests the interest rate is mainly determined by market demand and supply, and interbank market rates (such as 7-day repo rate and 1yr SHIBOR) also fell during the past month, this 103bp drop in the Treasury deposit rate demonstrates that the PBoC had intended to guide for lower financing costs.

The cut in the 3-month treasury rates – even as both the 7-day repo, 1 Year MLF and 1 Year Deposit rate all rate remained unchanged – is shown below.

As Nomura’s Asia Economist Ting Lu further writes, the recent decline of interbank rates due partially to the RRR cut effective 5 July suggests that the PBoC has delivered the “adequate liquidity conditions” to the interbank market, as it said it would in the briefing of the PBoC’s Q2 monetary policy committee meeting. However, the transmission channel appeared to have been choked as a certain proportion of lenders were reluctant to lend to the private sector amid the government’s deleveraging campaign, rising bond defaults, crash of the P2P lending bubble, and growth slowdown.

Explanations for the move varied, with ING Bank suggesting that cut was triggered by China’s lower Q2 economic growth, and as evidence, the bank notes that in June 2016 the PBOC also used the government deposit rate as a tool to cut interest rates when quarterly growth slowed.

Nomura’s explanation was similar, with the bank noting that the cut was due to the worse-than-expected domestic slowdown and potential fallout from trade tensions with the US, resulting in Beijing having “little choice but to pause on its deleveraging campaign” and starting a new round of stimulus.

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What happens next? According to Nomura, in the near future, Beijing will roll out more policy easing and stimulus measures in H2, to mitigate the ongoing credit squeeze and growth slowdown. The bank cited the spokesman of National Development and Reform Commission (NDRC) who said that the NDRC will “focus on bolstering areas of weakness, moderately increase effective investment, improve domestic demand, push forward market reforms in some key areas, and stimulate the market vitality” and “that the NDRC will improve the “flexibility” of macro policies and make sure to maintain a stable economic growth.”

Meanwhile, ING Bank also expects further easing, predicting the PBOC will cut the reserve requirement ratio at the beginning of each quarter from now to 1Q 2019 and may continue if trade war escalates.

The question is what happens after: after all China engaged in full-blown – and painful – deleveraging for a reason, and it is about to undo it. Well, as ING simply states, the marginal impact from the new easing “won’t be enough to support the economy.“

Nomura is just as skeptical, warning that these incremental measures “could lead to even bigger problems in the medium- to long-term, although in the short term they might be able to stabilise both financial markets and economic growth.”

The actual impact remains to be seen. Banks may still be reluctant to invest in risky high-yield bonds even if the PBoC provides the funds via MLF, and markets could soon realise that forcing banks to buy high-yield bonds may not be positive for the banks’ health and market valuations. The monetary transmission channel could still be clogged if banks refuse to abandon their cautious stance.

In conclusion, the Japanese bank expects more easing and stimulus measures in the second half to mitigate strong headwinds on growth.

But the biggest risk is how Trump will respond to not only the ongoing crash in the Yuan, which as Trump observed today in his CNBC interview, is “dropping like a rock“, but what to now appears to be an aggressive – if stealthy – easing cycle. After all, Trump made it very clear that he too prefers lower rates, and more importantly, Trump admitted that his Fed criticisms were “unusual” but said he doesn’t care.

So how long before the trade war, which is already shifting to currency war as a result of the recent record devaluation in the yuan, also become a central bank war and a renewed race to the bottom between the world’s two most important economies?

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